What, if anything, did the GameStop saga teach us?

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People walking by a GameStop.
People walk by a GameStop in lower Manhattan in September 2019, soon after the company announced it would close up to 200 stores due to a drop in sales. | Spencer Platt/Getty Images

What happened with GameStop exposed some real problems with the market. Nobody knows quite what to do about it.

Plenty of smart people think that someone should do something about whatever happened with GameStop in January. But there’s not much consensus around what that something should be — or what the problem is in the first place.

That the saga itself could even happen feels pretty wild. Some guys on a raunchy Reddit forum called WallStreetBets helped to drive up the price of a mall-based gaming retailer to the point that they cost some big hedge funds a bunch of money. The chaos reached such great heights that the trading platform Robinhood and others halted trading on GameStop and other super-hot stocks temporarily, sparking conspiracy theories about their reasoning and, likely more accurately, igniting concerns about how they could be so unprepared for what happened in the first place.

A litany of lawmakers have weighed in on the drama, including Alexandria Ocasio-Cortez, Ted Cruz, Elizabeth Warren, and Ro Khanna, seizing on the populist appeal of the matter, the David vs. Goliath feel of it. So have the White House and the Federal Reserve. Federal and state regulators are reportedly probing various aspects of and players in the saga. Wall Street bigwigs and ordinary people alike are wringing their hands. The House Financial Services Committee is hosting a virtual hearing on GameStop, with the major players in the incident attending.

“Many Americans feel that the system is stacked against them, and no matter what, Wall Street always wins,” said House Financial Services Committee Chair Maxine Waters (D-CA) during the committee’s GameStop hearing on February 18. “In this instance, many retail investors appeared motivated by a desire to beat Wall Street at its own game, and given the losses that many retail investors have sustained as a result of volatility in the system, there are many whose belief that the system is rigged against them has been reinforced.”

The GameStop saga exposed some real issues in the stock market worth examining — the enormous risks hedge funds take, how heavily they can short (as in, bet against) stocks, the ways platforms like Robinhood work (and don’t), and the ways individual investors can move the market. It also reinforces the idea that, at the end of the day, the big guys usually win.

In a sense, what happened with GameStop is that the system worked how it was supposed to. In another sense, it made it hard not to wonder why that’s how the system works.

It’s also difficult to develop a policy or regulatory solution when no one quite agrees what the problem is. “I bet there is going to be regulatory action, but we don’t know what the consequences are, the ramifications,” said Pauline Bell, an analyst at CFRA Research. “Sometimes you introduce a certain rule and you think it will increase everyone’s welfare, producing benefits, but in reality, it uncovers certain problems.”

A brief reminder of what happened with GameStop

The long and short of the GameStop saga (of which there’s a full explainer here) goes something like this: GameStop is a mall game retailer that hasn’t been doing so great, because a) nobody really goes to malls anymore, and b) especially during a pandemic. It sort of missed the e-commerce train and has struggled to catch up. Multiple hedge funds picked up on this, and so they shorted GameStop’s stock, betting that its price would go down. (When you short a stock, you borrow it, usually from a broker-dealer, sell it, and if the stock goes down, you buy it back at a lower price, return it to its original owner, and keep the difference. If its price goes up, you run into trouble; more on that later.)

Not everyone agrees GameStop is a lost cause, including some individual investors, sometimes referred to as retail traders, who gather on a Reddit forum called WallStreetBets. And over the past several months, momentum has been building there around GameStop, in part because of a Massachusetts man named Keith Gill, who on YouTube talked about his case for the company under the pseudonym Roaring Kitty and on Reddit talked about it as DeepFuckingValue.

Beyond believing in the business case for GameStop, retail traders on Reddit noticed that the stock was heavily shorted and recognized the opportunity for a short squeeze. In tandem, they were able to help drive up the stock’s price, and that eventually forced shorts betting against the stock to buy it to try to stem their losses. That, in turn, pushed the price even higher.

So in January, there was a big run on GameStop, which pushed the stock price super high, into the $300, even $400 range. It may have started with Reddit, but it didn’t stay there — plenty of institutional investors likely piled into the GameStop trade as well.

The stock’s meteoric rise hurt hedge funds shorting the stock, such as Melvin Capital, which lost 53 percent in January. The retail trading app Robinhood also wound up in hot water because it temporarily restricted trading on GameStop and other “meme” stocks, meaning stocks that were taking off among retail traders. That angered some investors, because they were able to sell the stock but not buy it on Robinhood, while institutions trading elsewhere faced no such restrictions. At first, it didn’t explain why, and its explanations are still a little weird, but what seems to have happened is that things got so wild that Robinhood didn’t have enough money on hand to really deal with it. That’s not to say the app shouldn’t have been better prepared. It just wasn’t.

Ultimately, Melvin got $2.75 billion from two other hedge funds and lived to see another day. The same goes for Robinhood, which raised $3 billion. Some of the retail traders who put money into GameStop — especially those who got in early — made money. A lot lost, too. At its peak, GameStop was trading at $483. It’s now back down below $50.

There are already rumblings of some probes related to Robinhood, Reddit, and other angles of the GameStop frenzy. Even Gill is under scrutiny. And Robinhood, to be sure, is no stranger to regulatory pressure, nor is Wall Street writ large.

GameStop was sort of a lesson in how some behind-the-scenes trading mechanisms work

Even the people who got in early on GameStop recognized what was happening in January wouldn’t end well. That includes Rod Alzmann, on Reddit better known as Uberkikz11, who says he started buying into GameStop in 2017. (His average buy price is now under $6, his average sell around $270, meaning he made money.) He recalls when Elon Musk tweeted about GameStop (or, rather, “Gamestonk!!”) on January 26. “I was like, okay, this is peak mania, this is completely untethered from reality,” Alzmann, who has launched a GameStop-dedicated website, said.

There are some legitimate questions to ask here. GameStop was more shorted than there were shares, which is odd but probably not illegal. Robinhood has been cagey in exactly what happened when it paused trading (it took the app about a day to explain its reasoning), and its CEO, Vlad Tenev, hasn’t always been consistent in his public statements. The Securities and Exchange Commission has said it plans to review actions taken by the entities it regulates that “may disadvantage investors or otherwise unduly inhibit their ability to trade certain securities.” It’s also reportedly looking at transparency requirements around short selling. Big market-makers such as Citadel Securities and Virtu pay millions of dollars to process the trades on Robinhood and put them back onto the market, in turn presumably making money off the spread, which is the price difference between the buy and sell. The practice, called payment for order flow, has come under scrutiny.

Gill, a.k.a. Roaring Kitty/DeepFuckingValue, turned out to be somewhat smart on stocks: He used to work for a Massachusetts insurance company and was a registered broker. Massachusetts regulators are investigating Gill’s activities — legally, he was supposed to inform his employer of his activities, and his company, MassMutual, has said he did not. Broadly, it’s also sensible to wonder about the role of social media in finance and investing decisions.

Beyond the specifics of GameStop, it’s also worth looking at the broader retail trading trend, including how Robinhood has gamified trading and what sorts of guardrails should be around the big guys and the little guys in the stock market. Especially when the little guys say, not unconvincingly, that they should have the same liberty to take risks as the hedge funds and other big players.

“This time, it seems like if we take Redditors to be retail investors and take them to be Main Street, they don’t want their protections,” said Gina-Gail Fletcher, a professor of law at Duke University.

So what should be done? It’s complicated.

It’s worth looking at some of the big systemic stuff

Robinhood appears to have paused trading on certain meme stocks in January not because of some secret deal with market-makers but instead because it didn’t have enough collateral to meet clearinghouse requirements during the surge in trading. A clearinghouse is a sort of financial intermediary that finalizes transactions and make sure the buyers and sellers hold up their end of the bargain.

“Robinhood needs to have clearer disclosure requirements for capital risk, and there needs to be greater requirements for capital reserves,” said Rep. Ro Khanna (D-CA). “Robinhood should say clearly if trading gets to this level and this frenzy, we can’t trade, or there should be higher reserves for Robinhood and higher disclosure requirements for clearinghouses.”

Joshua Macey, an assistant law professor at the University of Chicago, said it would also be good to have more transparency around how payment for order flow works to understand better what makes it a worthwhile endeavor for market-makers, and to better know just how much power clearinghouses have in the economy. “It did reveal something of systemic importance that’s interesting, which is that clearinghouses have surprising effects both on retail investors and systemic risk,” he said.

Citadel Securities and Robinhood have both argued that the payment for order flow system is a good one. One thing that is true: It is how Robinhood and other brokers do commission-free trades for investors, and if the practice were to end, those businesses would have to change their business models, including potentially charging for trades.

Generally, it takes two business days after the day a stock is traded for the order to actually be settled (meaning once it finally gets from the seller’s account to the buyer’s) in a system that’s called T+2. In the aftermath of GameStop, Robinhood has begun to advocate for real-time settlement, meaning trades would be settled instantaneously. In his House testimony, Citadel Securities founder Ken Griffin argued for shortening it to one day, so a T+1 system.

The SEC shortened the settlement period from T+3 to T+2 in 2017, so making changes to it wouldn’t be unheard of. Fletcher said it’s reasonable to ask whether two days makes sense, given technological advances. “We need to start having a conversation about what that market infrastructure looks like when we still need two days to settle transactions,” she said.

Shortening settlement times would be a heavy and expensive lift, and experts tend to err on the side of T+1 over T+0. It’s also unclear how much settlement periods had to do with what happened with Robinhood during the GameStop craze — especially if the problem was not having enough credit lines and capital to draw on.

We need to keep talking about Robinhood

Robinhood has been at the forefront of the retail trading boom, and attention to it isn’t going away. In late 2020, the company agreed to pay the SEC $65 million as part of a settlement over charges that it didn’t sufficiently explain to customers how their trades were being routed and how it makes money. This is an issue Sen. Elizabeth Warren (D-MA) has taken up, in letters to the company pressing it for details on how its business works and its ties to market-makers. She is also urging regulators to examine its practices and has pressed Citadel Securities on its relationship with Robinhood.

Experts say it would likely be good for Robinhood to disclose more to people trading on the platform about the potential risks they’re undertaking. Robinhood is gamified and makes investing feel like gambling. In 2020, a young man died by suicide after believing he’d lost hundreds of thousands of dollars on Robinhood; his parents are now suing.

Still, it’s hard to decipher what level of oversight is appropriate for retail traders. After all, some of what happened on GameStop are plays Wall Street runs all the time. It’s hard to argue average investors should be locked out of the public market because it’s risky (they are already locked out of much of the private market, a conversation that’s also starting to bubble up post-GameStop), but that then leaves you with disclosures.

“It just seems like those types of brokers will have to do more on the disclosure front, and that costs money, and that could potentially turn away some of their customers that don’t want to go through the nitty-gritty of details, they just want to have access to the app,” Bell said.

Robinhood could use more warning signs, even if the company and its investor base don’t love it. And ultimately, no one can force traders to heed warnings. During the GameStop episode, there were plenty of people warning investors against buying the stock when it was trading so high, and a lot of them didn’t listen. “To some extent, I say go with God,” Fletcher said.

The New York Stock Exchange paused trading on GameStop during moments of heightened volatility, which is par for the course when stocks start to swing violently. The SEC could have stepped in to halt trading to slow things down, which some people argued it should have done. That may have tamped down the hysteria, but the SEC can’t halt trading forever. And in the heat of the moment, what traders wanted was to trade GameStop more, not less.

Day trading and WallStreetBets are here to stay

According to Bell, small investors now account for about 20 percent of trading volume, compared to 10 to 15 percent pre-pandemic. And she doesn’t expect this to fade. “Market volatility and the elevated participation rate by retail investors are here to stay even after the pandemic is long gone,” she said.

And so the discussion about how regulators and policymakers should approach this new normal is going to continue. How do you deal with traders who are organizing online in a way that can sometimes be effective? What are the rules they need to play by, and how do they compare to the rules institutions face?

There has been some chatter about whether what is happening on Reddit and other parts of the internet counts as market manipulation or as pump-and-dump schemes. Market manipulation is always hard to prove, whatever the scenario, and saying you like GameStop or whatever stock online is free speech.

Moreover, rich guys, including short sellers, are vocal about which stocks they do and don’t like all the time. Part of what precipitated the GameStop short squeeze was that Citron Research, run by known short seller Andrew Left, was posting on social media about how GameStop’s stock price should be lower. Short sellers talk about their belief that a stock is overvalued in hopes that others will go along with them (otherwise, the play doesn’t work); it’s just that the other part goes unsaid. Some users on Reddit were clear that part of the goal was to pile into GameStop to hurt institutional short sellers, some of them gamers feeling a certain nostalgia for the company.

“The behavior is completely identical in every respect except the unsophisticated guys just don’t know there’s one sentence they shouldn’t say,” Macey said. “You can’t tell people what you’re trying to do.”

To be sure, Reddit is anonymous, and it’s possible, if not probable at this point, that people who work at hedge funds and other institutions may be talking up their stocks there. Short sellers can often be stealthy about their positions, and so, yet again, the question of how much transparency should come from an anonymous person on the internet should be accompanied by — and probably outranked by — questions about how much transparency should come from people betting against stocks.

It’s still unclear what, if anything, will come from the GameStop saga. The SEC under President Joe Biden is likely to be more stringent in its regulatory and enforcement endeavors than under his predecessor, but whether it will focus on day traders remains to be seen. Much of its mission is to protect them from Wall Street predators and tricks — but some of the question here is also how much to protect them from themselves.

None of this is to say regulatory and policy interventions shouldn’t happen — there’s plenty of room to continue to talk about reining in Wall Street and worry about the financialization of the economy. But to focus it through the lens of the one instance in which at least some small-time traders won is a little awkward. “It’s a really strange message to send that when sophisticated investors are struggling, that’s when we’re going to step in to protect markets,” Macey said.

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